Investors Are Getting Worried About An Inverted Yield Curve

April 18, 2018

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To Citigroup Inc., the chances are slim that the U.S. enters a recession
anytime soon. Officials at the Federal Reserve feel the same way.

Yet both camps agree that an inverted Treasuries yield curve would be an
ominous sign for growth. And with the latest bout of flattening, the reality of
sub-zero spreads may soon collide with an otherwise sanguine outlook on the
economy.

The yield curve from 5 to 30 years flattened Wednesday to as little as
29 basis points, the narrowest spread since 2007. From 2 to 10 years, the gap
touched 41 basis points, also the smallest in more than a decade. For extending
to 10 years from 7, investors pick up a mere 4.3 basis points, less than a
quarter of what they got a year ago.

If the barrage of Fedspeak this week is any indication, the persistent
flattening is creating a dilemma for officials, who appear intent on gradually
tightening policy. St. Louis Fed President James Bullard was the latest to
weigh in, saying that central bankers need to debate the yield curve right now,
and that it could invert within six months.

On the one hand, bond traders are finally starting to come around to
officials’ path of hikes, with the unemployment rate the lowest since 2000 and
inflation creeping higher. But stubbornly low long-term yields could eventually
force the Fed to slow down, unless policy makers are willing to push the curve
below zero.

Fed Sensitivity

“The Fed is going to be very sensitive to the shape of the yield curve,”
said Katherine Renfrew, a portfolio manager at TIAA Investments, an affiliate
of Nuveen. “If we get to the point where inversion might begin to happen, the
Fed may put the brakes on further dialing back monetary stimulus.”

Something will have to give -- at least, if the Fed wants to keep
investors from speculating that a recession is approaching. It took about six
months for the curve from 5 to 30 years to flatten from around 30 basis points
to zero in 2005-06. The curve from 2 to 10 years narrowed from about 40 basis
points to zero in a similar amount of time. That puts both on track to invert
by year-end.

“A potential curve inversion should be taken as seriously as always,”
Citigroup analysts led by Jabaz Mathai wrote in an April 13 report. “The
historical relationship between the curve and implied recession probabilities
is highly non-linear: implied probabilities grow very fast when the curve
moves into inverted territory.”

In the report, Mathai argued that the Fed is wrong on the yield curve,
again. He noted that in 2006, then-Chairman Ben S. Bernanke said he didn’t see
inversion as portending an economic slowdown.

Last month, current Chairman Jerome Powell said “there are good
questions about what a flat yield curve or inverted yield curve does to
intermediation.” Though he added: “I don’t think that recession probabilities
are particularly high right now.”

At that time, yield spreads were about 10 basis points wider from 2 to
10 years, as well as from 5 to 30 years.

Of course, a pullback could happen at any time. BMO Capital Markets
strategists, who have remained firm on their forecast that the yield curve will
invert in 2018, said in a note Tuesday that there could very well be “a
tactical bump steeper as momentum is exhausted.” The yield spreads ended
Wednesday little changed.

Yet trading flows indicated lasting wagers on narrowing spreads. For the
second day in a row, a put option on the 30-year Treasuries futures contract
was heavily sold, a sign of confidence that long-end yields won’t
rise much. And a large block trade helped temporarily push the curve from
5 to 30 years below 30 basis points, through a key level highlighted by BMO.

Small Comfort

That’s not much comfort for investors positioned for continued economic
expansion. After the yield curve from 3 months to 10 years inverted in January
2006, it took less than two years for the Great Recession to begin.

A truly inverted curve “is a powerful signal of recessions” that
historically has occurred “when the Fed is in a tightening cycle, and markets
lose confidence in the economic outlook,” John Williams, the next president of
the New York Fed, said Tuesday. He said that’s not the case now.

He has a point. The curve is collapsing partly because the Treasury is
ramping up issuance of shorter maturities to fund expanding budget deficits.

Yet the curve from 5 to 30 years is approaching unprecedented territory
after flattening for nine straight sessions. The spread has only narrowed 10
consecutive times on a few occasions.